Project on Indian Financial Market Structure
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Capital Market Structure

Capital market structure has evolved over time with the market practices and conditions generally reflecting the policies put in place. Till the onset of reforms in the early 'nineties, raising of resources in the primary segment of the market was subject to several controls, disallowing the pricing to be determined by market conditions. Trading in the secondary market was subject to opaque practices. The trading and settlement system was outdated and out of tune with internationally followed practices. The volumes, however, increased and securities continued to exist in the physical form. Physical securities also created uncertainties for investors and increased the transaction cost. Besides, long and uncertain settlement cycles created serious problems for clearing houses. Informational flows to the market participants were also deficient. As the process of price formation has to be efficient for the growth and stability of the market, it was considered necessary to orient the Securities and Exchange Board of India (SEBI) to undertake the tasks of regulation and supervision. The SEBI was, for this purpose, given statutory powers through a separate legislation in 1992.

Raising of capital from the securities market before 1992 was regulated. Under the Capital Issues (Control) Act, 1947, firms were required to obtain approval from the Controller of Capital Issues (CCI) for raising resources in the market. New companies were allowed to issue shares only at par. Only the existing companies with substantial reserves could issue shares at a premium, which was based on some prescribed formula. In 1992, the Capital Issues (Control) Act, 1947 was repealed and with this ended all controls relating to raising of resources from the market. Since then the issuers of securities could raise the capital from the market without requiring any consent from any authority either for making the issue or for pricing it. Restrictions on rights and bonus issues have also been removed. New as well as established companies are now able to price their issues according to their assessment of market conditions. However, issuers of capital are required to meet the guidelines of SEBI on disclosure and investor protection. Companies issuing capital are required to make sufficient disclosures, including justification of the issue price and also material disclosure about the 'risk factors' in their offering prospectus. These guidelines have served as an important measure for protecting investor interest and promoting the development of the primary market along sound lines.

After the CCI regime was discontinued, the mechanics of determining offer price assumed importance. Initially, only fixed price mechanism of floating new capital issues was followed. This method of floatation, however, suffered from a drawback in that it was not easy to determine the price at which the market would clear the issue and, thus, could lead to either underpricing or overpricing of an issue. The empirical evidence in many countries suggests that new capital issues are normally underpriced. This results in transfer of wealth from the issuer to the investor, entailing, in the process, a cost to the issuer. As the method of offering shares at a fixed price by the issuer has proved to be not efficient, an alternative mechanism of book building has become popular in many countries. Book building mechanism is a method through which an offer price of an Initial Public Offering (IPO) is based on investors' demand. The book building mechanism which was introduced in 1995 gave the issuer the choice to raise resources either through this or the fixed price mechanism. Although the book building guidelines were prescribed in 1995, no issue was floated due to certain restrictive guidelines, which were modified in 1999. In terms of the extant guidelines issued by the SEBI, an issuer has been given the option to book build either 90 per cent of the net offer to the public or 75 per cent of net offer to the public. The balance issue is offered to the public at the fixed price determined through the book building exercise. In the 75 per cent book building scheme, the allotment in the book built portion is required to be only in the dematerialised form. The book building mechanism of floating new capital issues has been devised in such a way that small investors are also able to subscribe to securities at a price arrived at through a transparent process.

As the book building process is both time and cost-effective, it is becoming quite popular. This can be gauged from the fact that during 2000-2001 (April-October), 12 issues for an aggregate amount of Rs.1,256 crore (constituting 40.2 per cent of the total resources raised from the public issue market) were floated using book building mechanism as against 4 issues aggregating Rs.516 crore (constituting 6.7 per cent of the total resources raised) during the entire year of 1999-2000.

Both BSE and NSE offer their infrastructure for conducting on-line IPOs through book building. A related development has been the efforts to market IPOs through the existing secondary market infrastructure (trading terminals of stock exchanges, brokers, etc.). The SEBI has already approved a proposal of marketing of IPOs through stock exchanges and the guidelines to this effect are expected to be issued shortly. Once implemented, the system would help to overcome the inherent disadvantages faced by issuers and investors in the form of reduction of load on the banking and postal system and saving of time and cost associated with the process of new capital issues.

The efficiency of automated vis-à-vis floor-based trading system in the secondary segment of the market is widely debated, although the evidence around the world suggests that markets are moving away from the floor-based trading system. Over time, floor-based trading is likely to disappear, going by the trends noticed so far. Transparency is the major factor in debates over floor-based system versus electronic system and proponents of the automated system contend that floor-based trading is inefficient and less transparent. Many major international stock markets, such as, London, Paris, Toronto, Frankfurt and Sydney, conduct electronic trading.

Till recently, trading on the Indian stock exchanges took place through open outcry system barring NSE and OTCEI, which adopted screen-based trading system from the beginning (i.e., 1994 and 1992, respectively). At present all other stock exchanges have adopted on-line screen-based electronic trading, replacing the open outcry system. Of the two large stock exchanges, the BSE provides a combination of order and quote driven trading system, while NSE has only an order driven system. In an order driven system, orders from all over India are entered into the electronic system and matched directly on a continuous basis without the involvement of a jobber or market maker. In a quote driven system, the market makers offer two way quotes and are ready to buy and sell any quantity. With the introduction of computerised trading, members could enter their orders/quotes on work stations installed in their offices instead of assembling in the trading ring. All stock exchanges operating in India have over 8000 terminals spread wide across the country. In pursuance of the announcement made in the Union Budget 1999-2000, the SEBI issued guidelines for opening and maintaining the trading terminals abroad. While no trading terminal could be opened abroad due to high cost of connectivity, the permission of internet trading provides an alternative as the investor in any location could route the order through the internet for execution on the Indian stock exchanges. For ensuring greater market transparency, the SEBI has recently banned negotiated and cross deals (where both the seller and the buyer operate through the same broker). In September 1999, all private off-market deals in both shares as well as listed corporate debts were banned. All such deals are now routed only through the trading screens.

There are three main advantages of electronic trading over floor-based trading as observed in India, viz., transparency, more efficient price discovery, and reduction in transaction costs. Transparency ensures that stock prices fully reflect available information and lowers the trading costs by enabling the investor to assess overall supply and demand. Owing to computer-based trading, the speed with which new information gets reflected in prices has increased tremendously. The quantity and quality of information provided to market participants during the trading process (pre-trading and post-trading) having significant bearing on the price formation has also improved. Besides, the screen-based trading has the advantage of integrating different trading centres all over the country into a single trading platform. It may be noted that prior to screen-based trading, the very presence of stock markets in different regions implied segmentation of markets affecting the price discovery process. Investors in other locations were, under such conditions, unable to participate in the price formation process at the major stock exchange, namely the BSE. However, with screen-based trading spread across various locations, the process of price discovery has improved in the Indian stock markets. Screen-based trading has also led to significant reduction in the transaction cost since it enabled the elimination of a chain of brokers for execution of orders from various locations at BSE and NSE.

The capital market has widened and deepened considerably in the recent years with enlargement of participants and emergence of new instruments. In the Indian capital market, traditionally mainly two instruments were traded, i.e., debt and equity. However, starting from the mid-'eighties and especially during the first-half of the 'nineties, a wide range of innovative/hybrid instruments combining both the features of debt and equity were introduced to suit varied needs of investors and issuers/borrowers. Besides DFIs, PSUs also issued many debt instruments with innovative features.

Markets have also widened with the increase in the number of players, such as, mutual funds and foreign institutional investors. There are now 34 mutual funds operating in the country with total asset base of over Rs. one lakh crore. At the end of November 2000, there were about 551 FIIs registered with the SEBI. They made investment to the extent of about US $ 11.5 billion in equity. With large investment base and active trading operations, FIIs now significantly impact the Indian stock markets.

The trading, clearing and settlement systems, which had suffered from several bottlenecks, have been considerably improved with measures taken to shorten the settlement cycle through the introduction of rolling settlement system in select scrips and acceleration of the process of electronic book entry transfer through depository.

Trading by member brokers is subject to some restrictions. These relate to margining system, intra-day trading limit and exposure limit. Each broker is subject to margins and to the trading limit, Various types of margins, such as, daily margins, mark to market margin, ad hoc margin and volatility margins to contain price volatility, are in place. There is also an intra-day trading limit, which is the limit to volume. Each broker's trading volume during a day is not allowed to exceed the intra-day trading limit. In case a broker wishes to exceed this limit, he or she has to deposit additional capital with the exchange. Thus, brokers are now required to have adequate capital in relation to their positions. With a view to enhancing market safety, the upper limit for gross exposure of the member-broker of the stock exchange has been fixed at 20 times of his capital. These restrictions have an impact on daily transaction volume and daily volatility.

The Indian stock market has, historically, adopted an account period settlement system whereby positions of brokers are accumulated till the end of a specified period and only the netted out positions with respect to every security are settled. The accumulation of position during the settlement cycle has given scope for speculative activities and, thus, increasing the possibility of default by participants. By combining the features of both cash and futures markets, the account period settlement also impeded the price discovery process. Further, the end of the settlement period, in the absence of significant borrowing and lending facility, has often witnessed erratic price movements. Although the account period settlement system through increased volume of trade, has tended to add to the liquidity in the system, there have been concerns over its ill-effects. As a partial remedy, the period of trading cycle was reduced from a fortnight to one week uniformly across all stock exchanges. The long-term solution to the trading system, however, rests with the alternative system of rolling settlement (RS), which is accepted and is being adopted in a phased manner. Under the RS system, any transaction made on a particular day necessarily results in delivery after a fixed number of days. The rolling settlement on a T+5 basis was introduced in select scrips numbering 10 in all in January 2000. Subsequently as on May 8, 2000, 153 more scrips were brought under the rolling settlement system. The introduction of rolling settlement, however, demands quicker movement of funds and securities. This, in turn, requires adequate developments in dematerialisation and electronic funds transfer (EFT) facility. While the process of dematerialisation is taking place satisfactorily through the existing depositories, efforts are afoot to improve and expand the existing EFT facility.

Safe and quick transfer of securities is an important element for smooth and efficient functioning of the securities market. Apart from the problems involved in the movement of physical security certificates, bad deliveries due to faulty paper work, theft, forgery etc. added to the transaction cost and restricted liquidity. To overcome these difficulties, legislative changes were carried out for maintaining ownership records in an electronic book-entry form. Under this mode, securities are transferred in a speedy and safe manner without interposition of issuers in the process, except in few circumstances. In order to catalyse the process of dematerialisation of securities and dematerialised trading, an element of compulsion was introduced by requiring the individual and institutional investors to settle trades compulsorily in dematerialised form in shares of select companies. At end-October 2000, there were 1415 scrips in which all investors -institutional and retail - were required to settle trades in dematerialised form. As at end-May 2000, 93 per cent of securities delivered for settlement by value at BSE and NSE combined together were in the dematerialised form. With progressive expansion of the list of securities in the compulsory dematerialised form, it is expected that more than 98 per cent of scrips traded on all exchanges would be in compulsory dematerialised form by end-March 2001.

One of the shortcomings of the clearing and settlement process of the Indian stock markets was the absence of a system to reduce counter-party risk. Managing this risk is essential for promoting a safe and efficient market. To provide the necessary funds and ensure timely completion of settlements in cases of failure of member brokers to fulfil their settlement obligations, major stock exchanges have set up Settlement Guarantee Funds. The aggregate corpus of the Fund at the stock exchanges is presently over Rs.1,000 crore. The NSE has set up a clearing corporation which guarantees settlement of all trades. The clearing corporation, thus, assumes the counter party risk involved in all the transactions.

All stock exchanges in the country have established clearing houses. Consequently, all transactions are settled through the clearing houses. In the past, while some transactions were settled through the clearing houses, others were settled directly between the members. Routing of transactions through clearing houses has substantially reduced the credit risk in the settlement system.

Circuit breakers were first introduced in 1987 in the U.S. in the wake of sharp fall in the share prices. To contain abnormal pric e variations, scrip-wise specific daily price bands or circuit breakers in India were introduced in 1995 whereby the trading automatically got suspended if the prices varied either side beyond 8 per cent; further trading was allowed only up to the price band. Price bands, which were originally fixed at 8 per cent, were relaxed in January 2000, whereby a further variation of 4 per cent in the scrip beyond 8 per cent, after a cooling off period of 30 minutes, was allowed. This was made applicable in the case of 100 scrips. In June 2000, for all scrips under compulsory rolling settlement, the price band was relaxed by 8 per cent (from 4 per cent earlier) with half an hour cooling period after the scrip had hit the initial price band of 8 per cent.

While recent experiences in some countries,, such as, Brazil, Taiwan and Thailand, showed that circuit filters were successful in slowing down the market momentum, there has been some controversy over the effectiveness of circuit filters over the medium to long-term. The opponents of circuit filters also cite their adverse effects on the process of price formation. In the recent Asian crisis, there were many instances when the price discovery process was impeded in the cash markets, spilling over subsequently to the futures markets as well. However, circuit filters are favoured mainly on the ground that they are the best available tool for containing volatility. This is based on the belief that containing of excess volatility helps to maintain investor confidence in the market.